The CBOE Volatility Index plunged Friday and is still hovering around its lowest levels of the year. More skittish investors, though, may interpret this as a sign of growing complacency in the markets and turn to VIX-related exchange traded funds to hedge their positions.
For instance, the iPath S&P 500 VIX Short Term Futures ETN (NYSEArca: VXX) and ProShares VIX Short-Term Futures ETF (NYSEArca: VIXY) are two popular ways to gain exposure to VIX moves.
SEE MORE: ETF Strategies to Hedge Against a Correction
However, potential investors should be aware that these VIX exchange traded products track the futures market and not the spot price of the VIX.
“These products, in general, do exactly what they promise to do,” Dave Nadig, Director of Exchange Traded Funds at FactSet, said in a research note. “They give you highly liquid, easy to access exposure to an incredibly narrow, highly volatile corner of the futures market, based on multi-layered derivative pricing and possibly daily resets (if you’re levered or inverse).”
[related_stories]However, since the ETPs track the futures market, investors will be exposed to issues like contango. Since the last two weeks of August when the VIX spiked above a 50 reading, inverse VIX ETP traders have made a tidy return, but nowhere near the spot price.
“The long speculator certainly made money, but nowhere during the few-hundred percent rise in VIX was there an opportunity to make more than about a 50% profit – in a futures market with a few-hundred percent annual headwind,” Nadig said. “Conversely, the short speculator lost nearly half their investment in a hurry. The presence of contango – and contango-hoarding sellers – acts as a dampener on the actual realizable gains from even the most prescient VIX ETF investor.”
SEE MORE: VIX ETFs Surge as Fear Grips Market
For example, VXX, which tracks the S&P 500 VIX Short Term Futures Index, rolls contracts every day to gain a notional exposure that is always 30 days out. However, since the VIX market is perpetually in a state of contango, where later dated contracts are costlier than near term contracts, the ETN is essentially selling low and buying high each time it rolls over its contract.
“This crippling contango is persistent in VIX futures for a pretty simple reason – the future is always unknown, and thus an estimation of potential outcomes has a wider variance than the driver of immediate volatility in the market, which is information,” Nadig said.
Consequently, as the ETPs roll over contracts in a contagoed market, investors may find their VIX ETP falling short of the spot price movements of the VIX.
For more information on the CBOE Volatility Index, visit our VIX category.